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Wednesday, December 26, 2012

Re-Engineering the Tax Code: Part II

Part II -- Closing Compensation Loopholes

In Part I we established that for this thought experiment, we need a new way of thinking about our be-loathed tax system. It just doesn't make sense to keep gluing new doodads (exclusions / extensions) onto the old one; the best thing we can do with the rusted old contraption is to toss it out and start over from scratch. Starting from scratch, we can implement 21st century concepts, materials, and thinking applicable to our 21st century economy.

Because this new system of taxation is being designed specifically to encourage businesses, organizations and/or entities with excessive profits to more generously reward the "low men on the totem pole," the progressive tax bracket system makes the most sense.

A business can choose to minimize total tax payments by paying its workforce more, or it can voluntarily pay more in tax than it must to when it chooses to keep profits concentrated among the few at the top. This system rewards benevolence and discourages greed, both at a corporate and individual level.

This progressive idea is the core strength of our system. Granted, our current system is progressive, but it's aggressive in the wrong direction... it's aggressive against low, medium, and even moderately well-off earners.

Continuing with our bicycle analogy, let's liken it to a design innovation -- visualize this fantastically awesome carbon fiber frame reinforced with Kevlar. This frame has made the "guts" the lattice for increased capacity to wear and tear with none of the dead weight of its predecessor; it does more with less, and it provides a good framework to hold together the rest of our moving parts.

Traditionally, the "corporate" tax rate structure has been different from the "individual" tax rate structure. Corporations create "jobs," right? That's why we have two different systems? Well that's what we're taught. In the industrial manufacturing economy, this was more true; it made sense to tax a corporation more aggressively on its profit (which does not include payments to workers; these numbers have already been subtracted out on the Income Statement).

Quick accounting concept here: income (AKA revenue) is not profit. At a very basic level, profit is what is left over after various business expenses have been subtracted. Yes, including the salaries of the executives and the wages paid to the employees. Companies like WalMart demonstrate a prime example of how the books can be cooked... A company like WalMart earns and extraordinary amount of income; it has very low costs of merchandise; and yet, it concentrates the majority of its profit among Sam Walton's heirs.

There are all kinds of lovely accounting / finance acronyms (NOPLAT, EBITDA) outside the scope of this article, but for the purpose of this discussion, the main point to take away is that the US tax code historically ignores business revenue and treats corporate profits differently from individual income, even though both are essentially the same when we think of them in the context of earned dollars with the potential to be taxed.

Historically, taxing business profit differently than worker pay, did NOT stop executives from underpaying workers; budget accountants have almost always had an incentive to minimize DL -- or "Direct Labor" costs (typically workers on the floor of the manufacturing plant / construction workers / wage-hour slaves) -- lower labor costs imply better efficiency, and greater efficiency means larger bonuses to managers and executives. Because of this practice, companies have always sought to pay laborers as little as possible, and erroneously rewarded executives and managers who erroneously and egotistically presume they are responsible for the "efficiency".

Plant managers and executives, driven by the need to minimize "costs," would run through workers, with no heed to overtime, working conditions or general welfare of the workers. Perhaps the only good thing to come out of this historical treatment is the federal minimum wage (which is another can of worms for another day).

So how to close the compensation loopholes? Here is one idea.

Key: Tax revenue inclusive of salaries and wages.

Historically,
if a business had, $2M in revenue and $1M in non-wage / non-salary expenses
for a net profit of $1M ($2M - $1M = $1M), the corporate tax would be
the same whether that business' $1M in payment expenses was $900,000 to
the CEO and $20,000 to each of its five employees, or if the $1M was
divided equally among all the workers. With our new system, we tax
revenue inclusive of salaries and wages; a business has tax
liability on the full $1M to be distributed. The actual tax payment due
will vary, and depend upon how it's divvied up. Thus, each dollar
"paid out" in the form of wages and salaries should be taxed only once;
the leftover profit residual to keep the business going would be
distributed tax-free to non-employee shareholders.

The result -- when applying this idea in tandem with the low-burden tax rate discussed in Part I, truly minimizes the costs of payments to the government, eases tax burden on the business and truly rewards employees.

Next time -- a discussion of reward-based risk for both employee and non-employee shareholders; dividends and "capital gains" for various investment vehicles.